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Energy Studies Review

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Issue 2 Volume 6 Article 3
11-10-1994
Changing Canadian Electricity Markets and the
Future Role of Government
Mark Jaccard
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Recommended Citation
Jaccard, Mark (1994) "Changing Canadian Electricity Markets and the Future Role of Government," Energy Studies Review: Vol. 6: Iss.
2, Article 3.
Available at: http://digitalcommons.mcmaster.ca/esr/vol6/iss2/3
Changing Canadian Electricity Markets and the Future Role of
Government
Abstract
The roles of two arguments from neoclassical economics for government intervention in the electricity
industry, based on the existence of natural monopoly and public goods, have been diminishing, while the
need to deal with negative environmental externalities has been given increasing attention. In recent debates
over appropriate policy responses, these rationales have frequently been treated in a confusing manner and
one encounters policy proposals that focus on one of the arguments while ignoring the others. The evolution
of these rationales is described and its implications for policy formation are considered. The paper concludes
with an illustration of how this analysis suggests a certain range of policy solutions, combined with substantial
room for distinct choices within that range.
This article is available in Energy Studies Review: http://digitalcommons.mcmaster.ca/esr/vol6/iss2/3
The roles of two arguments from neoclassical economics
for government intervention in the electricity industry,
based on the existence of natural monopoly and public
goods, have been diminishing, while the need to deal with
negative environmental externalities has been given in-
creasing attention. In recent debates over appropriate pol-
icy responses, these rationales have frequently been treated
in a confusing manner and one encounters policy pro-
posals that focus on one of the arguments while ignoring
the others. The evolution of these rationales is described
and its implications for policy formation are considered.
The paper concludes UJith -an illustration of how this anal-
ysis suggests a certain range of policy solutions, combined
with substantial room for distinct choices within that
range.
Deux argumentations d'inspiration economique neoclas-
sique, en faveur d'une intervention gouvernementale dans
Ie secteur de l'energie eIectrique, qui s'appuient sur
l'existence d'un nwnopole nature! et sur la notion de biens
publics jouent un role de moins en moins important alors
qu'on prete de plus en plus attention au besoin de traiter
les problemes extemes lies aux consequences negatives de
l'industrie sur l'environnement. Au cours des recents
debats sur l' elaboration de politiques appropriees en
riponse aces problemes, ces arguments ont souvent efe
abordes de maniere confuse et on rencontre des pro-
positions de politique qui se focalisent sur un des argu-
ments et ignorent les autres. L'article expose 1'evolution
de ces logiques d'argumentation et fraite de leurs impli-
cations en matiere d'elaboration des politiques. En con-
clusion, il ilIustre la maniere dont une teIle analyse
suggere qu'il existe un certain eventail de solutions en
matiere de politiques et en mOOe temps qu' une marge de
manoeuvre substantielle pennet d'effectuer des choix
distincts.
Mark Jaccard is Chairperson and CEO of the British
Columbia Utilities Commission and Associate Profes-
sor in the School of Resource and Environmental
Management, Simon Fraser University, Vancouver.
An earlier version of this paper was presented at the
International Seminar on Regulation: Energy, Environ-
ment and Finance at the University of Mexico, August
16-18,1994.
Changing Canadian
Electricity Markets
and the Future Role
of Government
MARK JACCARD
The appropriate role for government in the
electricity market has recently emerged as a
highly contentious issue. Although arguments
for government intervention have existed since
the electricity industry's beginning a century
ago, in recent decades two notable rationales
that have dominated for most of the century
are diminishing in importance, while a new
rationale is emerging. In the terms of neo-
classical economics, the first two rationales
centre around the concepts of natural monopoly
and public goods; the more recent rationale is
based on negative environmental externalities. The
first objective of this paper is to step back from
the day-ta-day debate in order to discern these
broader trends in the rationales for government
intervention in electricity markets, and to assess
their separate and combined implications
I
However, while the analysis of intervention
rationales is generic to the electricity industry
throughout the world, the appropriate policy
response depends on the specific characteristics
of each region or country. Thus, the second
objective is to assess the implications of these
industry-wide trends for government inter-
vention in Canadian electricity markets. Of
particular concern is the extent to which the
1/ Note that the issue addressed in this paper is
not simply one of public versus private ownership.
The concern here is with the broad question of the
appropriate degree of government intervention in
all its forms.
Energy Studies Review Vol. 6, No.2, 1994 Printed in Canada 103
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current trends will either force convergence
toward a single industry model or continue to
allow for the regional diversity that has
historically characterized the Canadian
electricity industry. Analysis suggests that there
are both forces for convergence and possibilities
for divergence, implying that some changes will
be similar, but that the level of government
ownership and regulation can still vary con-
siderably. In particular, private competitive
electricity generation markets will emerge
throughout the industry, as will more stringent
environmental regulation, but the degree of
government ownership and the form of envi-
ronmental regulation may differ significantly.
1. Past Rationales for Government
Intervention in Electricity Markets
The approach in this paper is to explain
government intervention in capitalist market
economies in terms of standard concepts of
neoclassical economics. This approach offers
certain advantages in terms of clarifying the
underlying fundamental issues in public debate.
But it should not be assumed that politicians
explicitly carry out this type of analysis when
making policies. The approach here is inter-
pretive rather than descriptive.
Neoclassical economics defines conditions
under which markets are unlikely to maximize
social welfare.
2
These conditions are generally
defined as market failures, and they provide
a rationale for government intervention in a
given market.
3
Two market failure rationales
for government intervention in electricity
2/ According to economists, social well-being (or
welfare) is maximized if consumers can freely
determine their consumption and if productive
resources are allocated to satisfy these consumption
demands in the most economically efficient manner
possible. Economists specify several conditions, in-
cluding perfectly competitive markets, that will
lead to welfare maximization.
3/ There is no guarantee that government inter-
vention will bring society closer to the social opti-
mum, which is why some argue against govern-
ment intervention even where market failure is ob-
vious.
104
markets have existed since that industry
emerged at the beginning of the century. The
first is based on the concept of natural
monopoly, the second on the argument that
electricity exhibits some of the characteristics
of public goods. A third argument, not discus-
sed in as much detail here, does not relate to
the market's failure to be efficient, but to a
social equity goal: the belief that the almost
universal provision of electricity at a cornmon
price is socially desirable.
1.1 Natural Monopoly
In some industries, the lowest possible
production costs can be achieved only if there
is one firm in the market. This type of market
is called a natural monopoly in order to dis-
tinguish it from markets in which an 'artificial'
monopoly exists, in that, if it were to be re-
placed by several competing firms, prices would
fall
4
In the electricity market, a capital intensive
distribution system is required and it is readily
apparent that redundant distribution systems
owned by competing firms would entail much
higher costs. Also, until recently it was assumed
that economies of scale in generating tmits
meant that one large unit would have a lower
cost of production than two or more smaller
units.
For society to capture the benefits of natural
monopoly, the general assumption is that
government intervention is required in order
to ensure that the monopolist operates effi-
ciently and does not gamer excess profits.
5
Governments have generally opted for one of
two major forms of intervention in electricity
markets. One is to countenance a private
monopoly, but to regulate it with a public
utility commission. The other is to establish a
publicly owned monopoly - in Canada a
crown corporation - overseen by one or more
of direct ministerial control, cabinet appoint-
4/ See Berg and Tschirhart (1988) for a formal
definition.
S/ Excess profitS are here distinguished from nor-
mal profits, the latter being a return to capital com-
mensurate with the investment risk.
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ment of the utility's board of directors, or a par-
liamentary review committee.
The dominant approach in Canada has been
to create crown corporations. Over 80% of
electricity generated in Canada is by vertically
integrated crown corporations owned by pro-
vincial governments (Table 1). However, the
Canadian model varies from province to
province, with only Alberta, Nova Scotia and
Prince Edward Island dominated by private
ownership, and with many provinces and terri-
tories having special characteristics, such as
small privately owned utilities or rnlU1icipal
utilities. Ontario Hydro, for example, delivers
power to over 300 municipal utilities (Natural
Resources Canada, 1993).
In its emphasis on public ownership, the
dominant Canadian model is similar to that of
Europe. In contrast, in the US, as in Alberta,
most major generating utilities are investor-
owned, regulated by public utility commissions.
Neither the regulation of private monopolies
nor the creation of crown corporation mono-
polies have been free of criticism as solutions
to the natural monopoly problem. In the case
of regulated, privately-owned utilities, two
criticisms have been particularly salient.
One criticism is that there is a tendency in
regulation to award excessive returns to capital,
thereby providing an incentive for utilities to
over-invest and to bias their investments toward
capital and away from labour and other
productive inputs (Averch and Johnson, 1962).
The second criticism emphasizes the difference
between regulatory theory and practice. It is
suggested that regulatory agencies are at risk
of "capture," such that they eventually confuse
the objectives of the regulated entity with those
of society (Stigler, 1971; Posner, 1974). Both of
these theories are difficult to prove or refute,
and efforts at empirical analysis have tended
to show that the regulatory process is much
more complex than either critical model would
suggest Uoskow, 1974)6
Over the years numerous reforms have been
6/ Kahn, A., (1988) and most other texts on electric
utility regulation review the inconclusive research
results.
suggested and implemented. These tend either
toward more careful scrutiny of utility manage-
ment decisions or toward efforts to better inte-
grate market mechanisms into the regulatory
process. The latter approach includes price caps,
which encourage greater efficiency effort by the
utility because cost decreases allow higher
profits in the period between cap reviews, and
franchise bidding, in which the monopoly fran-
chise is open to competitive bid at regular
intervals.
7
As for the public ownership model, two
criticisms stand out (Vickers and Yarrow, 1988;
Laffont and Tirole, 1993). The first relates to the
economic inefficiency that may result when
political concerns and the self-interest of utility
managers interfere in investment and operating
decisions. The second relates to the problems
for democratic societies due to the concentration
of power in the hands of managers of large
publicly owned corporations. Positions in the
debate about public ownership are, however,
often determined by broader ideological
perspectives. Those with a propensity to favour
market intervention will tend to be more open
to public ownership, and the converse, though
this dichotomy does not always hold with
respect to electricity, as shall be seen below in
the discussion of public good.
The debate about investment efficiency is
almost impossible to resolve empirically (Berg
and Tschirhart, 1988). Even if the publicly
owned monopoly were shown to have lower
prices, a non-interventionist would likely be
able to cite evidence of public subsidy, as these
frequently exist in the form of public debt
guarantees or low returns to public equity. Con-
versely, if a private regulated monopoly were
shown to set lower prices than a publicly
owned monopoly, an interventionist might
argue that the publicly owned monopoly had
simply done a better job of incorporating other
7/ See Joskow and Schmalensee (1983) and Moor-
house (1986) for detailed analysis of the options for
reforming utility regulation. Demsetz (1968) pre-
sents the case for franchise bidding and Shepherd
(1984) provides a counter argument to this ap-
proach.
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Table 1: Electricity Supply and Mode of Government Intervention
Electricity Demand
(Twh)
Electricity Supply
Source
Ownership of
Generation
Rate Regulation
hydro 95%
Manitoba 18.4
Saskatchewan 14.6
Alberta 45.9
British 57.3
Columbia
94% predominantly utility commission
private
95% predominantly utility commission
public
Newfoundland
PEl
Nova Scotia
New Brunswick
Quebec
Ontario
10.7
0.8
9.9
13.9
164.6
139.4
fossil
fuel
fossil
fuel
fossil
fuel
nuclear
hydro
hydro
fossil
fuel
nuclear
hydro
hydro
fossil
fuel
hydro
fossil
fuel
hydro
100%
89%
49%
30%
19%
96%
22%
48%
29%
99%
77%
22%
predominantly
public
private
private
public
public
public
public
public
provincial cabinet
utility commission
utility commission
provincial cabinet
provincial cabinet
provincial cabinet
provincial cabinet
provincial cabinet
relevant cost or equity considerations into its
decision making, suggesting that social welfare
was optimized even if commodity prices were
higher. Moreover, it can be argued that since
neither private nor public monopolies face the
discipline of the competitive market, the key
determinant of efficiency performance is to set
effective management incentives.
1.2 Public Good and Social Equity Concerns
The natural monopoly rationale alone is a
compelling reason for government intervention
in electricity markets. However, the specific
character of that intervention is influenced by
other factors. First, the propensity to favour
public or private ownership will differ. Second,
electricity is also seen as having other special
properties that invite government intervention.
Notably electricity is sometimes treated as if it
106
were a public good and as a necessity that
should be provided to all as a principle of social
equity.
A public good is defined as a good charac-
terized by non-exclusivity and non-rivalry. Non-
exclusivity means that the benefits of the good
cannot be withheld from anyone. Non-rivalry
means that use of the good or service by some
does not diminish its benefit to others. Thus,
for example, a lighthouse is a public good. It
is difficult or impOSSible to prevent particular
ships from benefiting from the services of a
lighthouse (non-exclusivity), yet their use of that
service in no way diminishes the benefits re-
ceived by others (non-rivalry). Because private
economic agents cannot capture in market
transactions all of the benefits of public goods,
public goods will generally be under-prOVided
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by markets
8
While it is difficult to describe any good as
a perfect public good, goods can be ranked
along a continuum with pure public goods at
one end and pure private goods at the other.
Electricity, the argument goes, is somewhere
along this continuum, closer to a pure private
good but nonetheless sharing some of the
attributes of public goods. These attributes
especially relate to the strategic importance of
the choice of resources and technologies used
in producing electricity, in that they influence
the general character of the economy. Pro-
ponents of intervention have apparently per-
ceived a jointly-<:onsumed return to society from
having government influence the choice of
resources and technologies used to produce
electricity. Similarly they see a public benefit
from government's control of electriCity-related
debt. Governments have frequently decided that
these public good attributes of electricity compel
their involvement in this sector. This sort of
argument is especially relevant for hydro and
nuclear power, but it can also be a factor with
oil or coal.
Hydro dams confer benefits in addition to
electricity, including irrigation, domestic water
supply, flood control, navigation and recreation.
Also, their costs can extend beyond the simple
costs of the physical structures, notably with
their impacts on migratory fish and animals.
In the past, the general assumption was that the
unaccounted for benefits far exceeded any
unaccounted for costs, meaning that hydro-
electric power would be under-provided by the
private market in the absence of public
intervention.
Nuclear power is another technology with
potential public good characteristics because of
its impact on the technological character of
economic development. A domestic nuclear
power industry results in a unique set of
technological skills, linkage industries and
export opportunities. Thus, the preference in
France today for the continued key role of
8/ Public goods can also be defined in terms of
externalities, as discussed further below. See Ran-
dall (1983) for a fuller description.
publicly owned nuclear power hinges primarily
on the emphasis on its public good attributes
(Boultes and Lederer, 1991; De Paoli and Finon,
1993). Others have agreed that nuclear elec-
tricity has public good attributes, but have
argued that these are mostly negative. Lovins
(1977), for example, argu.ed that nuclear
electricity is associated with greater risk of
nuclear weapons proliferation and security
requirements that condone excessive police
power.
These special characteristics of hydro and
nuclear power have influenced the character of
public intervention in Canada and elsewhere.
In all six Canadian provinces in which hydro
and nuclear power predominate, the generation
system is primarily publicly owned (Table 1).
In three of the remaining four provinces, based
mostly on thermal power, the generation system
is primarily privately owned. Even in the US,
with its preference for privately owned gen-
eration utilities, the two major publicly owned
generators were created in the 1930s in order
to develop the hydropower resources in the
Appalachians (Tennessee Valley Authority -
TVA) and in the Pacific Northwest (Bonneville
Power Authority - BPA). In the US, nuclear
power is privately owned, but in recent years
private utilities have ceased to expand nuclear
capacity. Elsewhere, nuclear is generally as-
sociated with public ownership; this includes
the UK, where a major privatization campaign
left nuclear within the public domain.
Even decisions about oil and coal use in
electricity generation have been seen to involve
broader public interest issues. The oil embargo
and price shocks beginning in the 1970s fostered
an energy security concern among oil importing
countries, and this in tum led to government
involvement in generation decisions. This was
a major reason for the French decision in 1974
to opt for nuclear. It also played a key role in
the generation choices in Japan and, to a lesser
degree, in most industrial cOW1tries. Domestic
coal resources are also perceived as offering
public good benefits, as has been the case in
Germany, either because of energy indepen-
dence or internal macroeconomic effects.
Finally, with any of the large scale tech-
107
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nologies, electricity generation investments can
represent a significant portion of total invest-
ment and increments in the debt of a country
or region. The timing and magnitude of such
decisions may have implications for counter-
cyclical macroeconomic policies, as well as for
trade and debt balances. This too can be viewed
as involving a public good and it invites
government involvement; that is, by influencing
these financing decisions the government can
create net benefit that would not be created by
leaving the decisions totally to the private
sector.
Governments have also been influenced by
the argument that electricity is an essential
component of modem society and that, as a
matter of social equity, the electricity grid
should be extended to all regions and prices
should be the same (within broadly defined
customer classes) regardless of differences in
the costs of proViding service. Such a policy
requires either subsidies across customers or
subsidies from taxpayers. Satisfying a social
goal in this way produces an outcome that can
be far from economically efficient and this
argument is thus generally at odds with the
other two rationales.
1.3 Intervention in the Canadian Electricity
Sector
Given the diversity and complexity of factors
motivating government intervention, it is not
surprising that the outcomes have varied
significantly, even within a single country. Thus,
while natural monopoly inevitably invites
public intervention, it is the public good
rationale and the propensity for market
intervention within a particular national or
regional society that tends to determine the
choice between public and private ownership
in the electricity sector. Canadian history
illustrates this point. Public ownership is usually
associated with the principal electricity
production technology (notably nuclear or
hydro power) and with the effort to frovide
electricity service to hinterland areas.
9/ For further background see Vining (1981).
108
British Columbia is one example. Prior to
1960, Vancouver was served by the privately
owned BC Electric, while hinterland areas of
the province were served by the publicly owned
BC Power Commission. Although the Social
Credit government of the 1950s and 60s would
qualify as a non-interventionist government, it
perceived large-scale hydropower development
as a precursor to economic development in the
province's hinterland regions. To realize this
objective, the government nationalized BC
Electric, creating BC Hydro in 1962, with
monopoly starus over most of the province, and
proceeded with simultaneous development of
the Peace and Columbia Rivers.
In Quebec, the motivating factors for
nationalization also had public good overtones,
although the specific issues were quite different.
The nationalization and consolidation of the
electricity sector was perceived by the reformist
Liberal government of the 1960s as a key
component in Quebec's effort to master its
economic destiny. In recent decades, Hydro-
Quebec served this objective by undertaking
major hydro-electric development in the James
Bay area.
Alberta provides a third variation. The
historical preference for non-interventionist
government in that province, and the key role
of thermal resources, have together contributed
to the development of an Albertan model that
closely resembles that of the US, a predominant-
ly private utility sector with regulation by a
utilities commission.
In contrast, Saskatchewan has traditionally
been noted for interventionist politics. Thus,
even though its electricity generation resources
are also predominantly thermal, its electricity
sector is publicly owned.
As examples in the US and elsewhere have
shown, government objectives can be realized
almost as easily with private ownership as with
public ownership. Thus, government efforts in
research and development, in addition to other
support, can influence private sector choices,
as has occurred in support of nuclear devel-
opment in the US, Germany and Japan. Utility
commissions also prOVide an opportunity for
the inclusion of various public values related
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to electricity's public good attributes and to
broader social equity concerns. Thus, utility
commissions throughout the US, and in Canada
where applicable, have been supportive in the
past of utility rates and policies that, among
other things, (1) applied uniform tariffs within
customer classes regardless of cost of service
differences, (2) subsidized uneconomic exten-
sions of service, (3) provided special tariffs and
services for low income customers or troubled
industries in regions suffering from economic
recession, and (4) explicitly favoured the devel-
opment of particular generation technologies
over others.
2. Emerging Forces of Change
Seen from the perspective of the 1990s, the three
decades following World War 11 were relatively
stable, at least in terms of the fundamental
characteristics of the electricity industry and
consequently with respect to the rationales for
government intervention. However, by the
1980s the cumulative effect of technological
evolution and changing public and political
concerns began to shift the debate about the
rationale for intervention in the electricity
industry. While the conventional rationale
focused on natural monopoly and public goods,
an emerging rationale relates to another form
of market failure - environmental externalities.
In addition, the strength of the two traditional
rationales have been eroded by developments
and changing public perceptions about the
desirability of market intervention. These chan-
ges have set off a broad ranging debate about
the appropriate roles for government and
industry in the electricity market, and have led
to substantial uncertainty about the future
character of that industry.
2.1 Environmental Concerns: the Externality
Rationale
Economists refer to most environmental impacts
as externalities - a negative or positive effect
of some activity that is experienced by a third
party but is not accounted for in an associated
purchase transaction or payment for damage.
The above discussion of public goods dealt with
positive externalities; the focus here is on
negative environmental extemalities
r
which
have been a key concern in the electricity sec-
tor.
lO
Because negative externalities are costs
that are not incorporated in final product prices,
the private market will produce more of the ex-
ternality-causing good or service than is optimal
for society.
Rising environmental awareness in the late
1960s and early 1970s had important impli-
cations for the electricity industry. Indeed,
virtually every major electricity generation
technology has been under an environmental
challenge since the 19705, with new concerns
emerging as earlier ones have been partly
addressed.n
Since the 1970s, the safety aspects of nuclear
power have been aggressively questioned, in
particular fuel transportation, plant operation
and waste disposal. This has become a political
issue in many countries, and Canada is no
exception.
Major hydro-electric projects are now
examined more rigorously and critically for
their environmental and social impacts and for
the non-market values of the land lost to
reservoirs. Recent hydro projects in Alberta, BC
and Quebec have all been associated with major
controversy because of their potential en-
vironmental and social impacts.
Combustion of fossil fuels in the generation
of electricity is now recognized as a significant
contributor to regional and local air pollution.
Acid rain, partly caused by electricity generation
has been a regional problem in eastern Canada
and the northeast US.
Depending on plant sitings, the nitrous
oxide emissions from fossil fuel-based electricity
10/ Negative social externalities have in some cases
also been very important. An example would be
uncompensated social impacts suffered by Cree
Indians from Hydro-Quebec's James Bay projects,
or the negative effects suffered by British Columbia
aboriginals and non-aboriginals due to the develop-
ment of the first Kemano project in northwest BC
in the 19505.
II/For details on the period prior to 1980, see
Roberts and Bluhm (1981).
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production can also contribute to urban air
pollution. Nitrous oxide is a precursor to low
level ozone, a critical air pollutant in the
Windsor to Quebec City corridor and in metro-
politan Vancouver.
The most recent environmental concern from
electricity generation is the risk of global climate
change associated with greenhouse gas emis-
sions. Fossil fuel-based electricity generation
teclmologies are again at issue, in this case
primarily because of their CO
2
emissions.
Governments have responded to these
environmental concerns in various ways. In part
this diversity is a result of differences in tech-
nology, but it is also explained by differences
in public perceptions and differences in pre-
ferred regulatory mechanisms.
In response to the concerns about nuclear
power, governments and regulatory agencies
have increased safety measures and conducted
detailed public reviews, resulting in substantial
cost increases for nuclear power in many
jurisdictions. In the US, these cost increases
have seriously undermined nuclear power's
ability to compete for new capacity require-
ments. In Europe there have also been intense
public debates about nuclear power, with
several countries, such as Denmark and
Sweden, ruling out future use of that tech-
nology. Less anti-nuclear sentiment has been
evident in countries such as France and Bel-
gium. Ontario Hydro has no active plans to
construct another nuclear plant, although it is
difficult to separate public policy intent from
the consequences of an economic downturn.
With few exceptions, most industrialized
countries are no longer willing to further exploit
their remaining large-scale hydropower poten-
tial.
12
Moreover, the full costs of past projects
are being re-assessed, notably because of cor-
rective expenditures and foregone generation
benefits (spilling water) required to mitigate
losses to other economic sectors, such as the
fishery. The most striking example is the major
12/ Quebec is an exception, but this policy is
seriously challenged by environmentalists and
some of the aboriginal peoples living in the area of
greatest hydropower potential, James Bay.
110
action taken to correct losses to fish resources
caused by earlier hydropower projects of the
BPA along the Columbia River system
13
Growing concerns for acid rain in eastern
North America and central and northern Europe
also led to regulatory responses that increased
the cost of electricity from fossil fuels, especially
coal. In the US, this concern culminated in the
federal government's Clean Air Act of 1990,
which set targets for total acid gas emission
from electricity generation and established a
tradeable permit system in an effort to achieve
the reduction targets at lowest total cost. In
Europe, the EC has set new emission standards
for generating plants, and is currently at-
tempting to encourage or subsidize similar
technological developments in eastern Europe.
The Canadian federal government and pro-
vincial governments have also tightened their
emission standards.
In terms of the local air quality impacts of
electricity generation from fossil fuels, regional
authorities in the Los Angeles basin are playing
a leading role, setting targets and devising
implementation mechanisms to reduce local air
emissions. This strategy has implications for the
choice of electricity supply technologies, the
siting of new generation plants, the retrofit of
existing plants, and dispatch decisions from
existing plants. Standards throughout the US
are set by the Environmental Protection Agency.
Similar efforts are underway or contemplated
in southern Ontario and the Vancouver region.
The climate change issue has only recently
become a serious concern of governments. Most
countries have now made general commihnents
with respect to stabilizing or reducing CO
2
emissions, but only a few specific policies have
so far been enacted. In addition to these policies
focused directly on the externality problem, the
recent shift in electric utility regulation toward
13/ The concern to correct damages to fishery
resources, combined with major misinvestrnents in
nuclear plants, provided a dual impetus for the
creation of the Northwest Power Planning Council
by the US government in 1980. Its general mandate
is to promote conservation in the planning proces-
ses of the BPA and the region's utilities, and to find
options for the recovery of fish stocks.
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encouraging energy efficiency is also seen as
a key policy response. While many would argue
that the energy efficiency initiatives among
utilities in the US in the 1980s were not initiated
for environmental reasons, these actions have
nonetheless had profound implications in the
debate about the appropriate government res-
ponse to the externality issue.
During the 1980s, US utility commissions
began to shift their focus from the least-cost
provision of electricity, the commodity, to the
least-cost provision of the services provided by
electricity, such as lighting, heating, motive
force, refrigeration, etc. Least-cost analysis of
electricity service provision frequently leads to
the conclusion that inveshnents in efficiency
would be more profitable than investments in
new supply. Programs to incite such invest-
ments are referred to as demand-side man-
agement (DSM). The process to ensure fair
comparison of supply and DSM options is
referred to as integrated resource plarming
(IRP). Utilities in most states in the US are now
mandated to conduct IRP and to implement
those DSM measures that are least-cost relative
to supply alternatives. Increasingly, the IRP
process includes public involvement via interest
group participation.
The causal factors for the regulatory shift
in the US are complex. First, many utilities had
over-invested in new capacity in the late 1970s
and early 1980s, and in some cases significant
shareholder losses were incurred when utility
commissions refused to allow complete recovery
of these inveshnents through rate increases.
Utility managers were, as a consequence, more
receptive to planning approaches that reduced
the risk of unrecoverable investments. Public
interest groups that had resisted major supply
investments, and subsequent price increases,
were generally enthusiastic in their support of
efforts to find alternatives to such investments.
Secondly, an underlying current in the debate
around these phenomena was the recognition
by many that there could be significant
environmental benefits from an emphasis on
energy efficiency14
14/ Lovins (1976) played a critical role in the
A third important factor was that many
utility commissions and participants in the
regulatory process became convinced of the
existence of several additional market failures
(or market impeifections) affecting energy
markets
15
Independent engineering and
economic analysis suggest that some consumers'
decisions about electricity consuming equipment
are non-optimal from the consumers' own
perspectives, and certainly non-optimal from
a social perspective. Several market imper-
fections have been suggested as the cause of this
apparent non-optimal behaviour. They include
lack of information, high transaction costs,
unnecessary risk aversion and imperfect capital
markets, among others.
16
This third factor -
market imperfections in consumer choices -
provided the rationale for greater intervention
in electricity markets, in this case to influence
consumer behaviour instead of the behaviour
of the utility.
Although the indirect environmental benefits
of DSM are frequently recognized - less
generation means less pollution - many utility
commissions in the US have also focused
directly on environmental externalities through
their ability to regulate the choice of electricity
generation technologies. In this sense, they have
taken over much of the market intervention role
that in other countries might be performed by
national and regional governments. Through
the IRP process, utility commissions are experi-
menting with various mechanisms to influence
the choice of generation technology, including
(1) applying percentage adders to the cost of
development and popularization of the argument
that promoting energy efficiency is a key com-
ponent of a sustainable energy future. See E. Kahn
(1988) for a review of the development ot lRP in
the US utility regulation process.
15/ While some have used the term market failure
in this context, others have preferred market
imperfection, so as to make a distinction between
these problems and the more conventional cases of
market failure involving externalities.
16/ There is an extensive literature on market
imperfections. See, for example, Fisher and Roth-
kopt (1989) and Krause et al (1993).
111
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environmentally damaging supply technologies,
(2) estimating monetary values for negative
externalities and internalizing these into the cost
of supply technologies when deciding between
technologies, and (3) establishing renewable set-
asides, to ensure that a certain percentage of
incremental supply will be from renewable,
environmentally benign, electricity generating
technologies, regardless of their cost (Rose,
Centolella and Hobbs, 1994).
There have been several criticisms of the
efforts of government and regulatory agencies
to deal with externalities in the electricity
market.
A general criticism, leveled by many eco-
nomists, is that governments have tended to
overlook the possible economic efficiency
benefits of using market instruments to achieve
environmental objectives. Ideally, the economist
would like to see envirorunental outcomes result
from the internalization into market prices of
externality costs. However, most economists
admit that it will be a long time, if ever, before
market values for all externality costs can be
determined and effectively internalized, and
even if that were to be achieved there is
uncertainty as to whether individual con-
sumption behaviour would lead to environ-
mental outcomes that are considered optimal
by most members of society. However, even if
society instead chooses to determine the desired
level of pollution (or pollution reduction) by
some other means, economists argue that it
should still rely on economic instruments to
achieve that desired level at minimal costs.
Pollution taxes and tradeable pollution permits
are frequently cited as examples of such
economic instruments.
But economists have not been the only
group disenchanted with government responses
to environmental externalities. Ecologists and
epidemiologists, in particular, have noted that
many of the effects of pollutants may not be
statistically detectable or may only emerge years
later. Moreover
f
non-linearities and critical
thresholds in ecosystems can make it extremely
difficult to develop reliable estimates of the
relationship between different levels of a
pollutant and the associated incremental
112
changes in environmental damage. As a
consequence
f
these scientists
f
and environ-
mentalists in general, argue that the government
response to the externality market failure should
be guided by the precautionary principle. Ac-
cording to this principle, the burden of proof
shifts so that actions possibly affecting the
environment are disallowed unless it can be
demonstrated with reasonable confidence that
no negative externality is likely. This argument
calls for a much greater government inter-
vention in the economy, in this case in a
preemptive manner. It would support, for
example, policies to favour specific technologies
(e.g., certain types of renewable electricity gen-
eration technologies) simply because these pose
less risk to the environment.
The rationale for DSM has come under
criticism
f
especially from economists. Some have
questioned the market imperfections listed in
support of DSM activity, arguing that estimates
of economic energy efficiency potential will tend
to overstate the achievable potential to the
extent that they ignore important intangible
costs and consumer surplus differences between
products (Sutherland, 1991)17 Others have
argued that estimates of economic efficiency
potential are exaggerated because of a failure
to account for the full costs of utility imple-
mentation of DSM and because, in estimating
savings, real world results should be used
instead of best practice engineering simulations
(Joskow and Marron, 1992). Economists are
more supportive of DSM if it is offered as one
17! This large debate can only be treated
superficially here. The argument is that estimates of
economic efficiency potential generally fail to
account for (1) differences in consumer surplus
between products that ostensibly provide the same
service and (2) intangible costs of more efficient
technologies. If the light of an incandescent bulb is
preferred to that of a compact fluorescent bulb,
there is a difference in consumer surplUS between
these two goods. Intangible costs relate to ad-
ditional perceived risk and/or transaction costs
because the more efficient product is generally
newer, less well known, less tested for reliability,
and therefore likely to be more troublesome (hence
costly) to find, shipf install
f
operate and maintain.
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of the means of responding to environmental
externalities or to correct the tendency of regu-
lators to set electricity prices at average cost
instead of marginal cost (assuming the latter
exceeds the former).
Finally, a key criticism of utility led IRP
processes as a response to environmental
externalities is that they may inadvertently
result in a worse outcome. The argument is that
actions at the state or provincial utility com-
mission level may actually decrease social
welfare because utility commissions only have
jurisdiction over certain energy forms and
certain energy companies. For example, an
effort to favour renewable, environmentally
benign, electricity generation technologies may
drive up the price of electricity such that
consumers switch to an alternative for a
particular end-use (say oil for space heating)
that happens to have an externality impact over
its life cycle even greater than the life cycle
impact of electricity as currently generated.
18
2.2 Erosion of the Natural Monopoly Rationale
The second force for change in recent times has
been an outcome of both technological evolution
and regulatory changes. As noted above, the
costs of conventional, large scale, electricity
supply technologies increased as a consequence
of regulatory responses to environmental
concerns, especially for nuclear and fossil fuel-
based technologies. In many jurisdictions, the
costs of nuclear also increased because of
unforeseen operating problems. Finally, these
technologies also experienced a general decrease
in the rate of advances in technical efficiency
Goskow, 1987; Hirsh, 1989). At the same time,
advances with other technologies have shifted
the cost advantage from large-scale back toward
small-scale technologies. This holds true es-
pecially for natural gas-based generation
technologies, the least polluting of the fossil
fuels, but it is also increasingly true for
alternative, renewable technologies, notably
18/ Life cycle costing is a methodology that incor-
porates all costs from production through to waste
disposal of a particular commodity or service.
wind, biomass, small hydro, geothermal and,
in some cases, solar. Among thermal techno-
logies, there has been a dramatic improvement
in relative unit costs for smaller scale units that
use a combined cycle for electricity generation
and/or cogenerate steam for industrial or do-
mestic uses.
Taken together, these technological deve-
lopments imply that past assumptions about
economies of scale in electricity generation are
less and less valid. Considerably smaller units
are now economically viable. This is especially
the case in private electricity markets, such as
the US, where the long amortization periods re-
quired by large scale technologies, such as
nuclear, are seen as more risky by private
investors. The full implications of this economic
shift are the subject of lively debate in the US
and now increasingly throughout the world.
The electricity supply industry consists of
three components: generation, transmission and
distribution. The broadest possible implication
of lost economies of scale in electricity gen-
eration is the elimination of the natural mono-
poly rationale for electric utilities, at least for
generation.
19
As a consequence, it. is now
increasingly argued that private competition at
the generation level is the market structure that
best maximizes social welfare. This would
replace the vertical integration model of the
electricity market structure with the model that
is emerging in the North American gas in-
dustry, one in which transmission and d i ~ t r i
bution utilities are separate from commodity
supply companies.
However, this argument for private
competitive markets in generation is not uni-
versally accepted. Positions in the debate de-
pend on how one trades off the decline in the
natural monopoly rationale against the other
rationales for intervention in electric markets.
19/ Ruff (1994) argues that the vertically integrated
electricity firm includes an additional natural
monopoly function, that of coordinating short-run
supply dispatch in order to ensure instantaneous
market clearing at all times; this is of particular
concern because of unique properties of electricity
transmission and because electricity cannot be
stored.
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In particular, even if the natural monopoly
argument for a monopoly in generation has
diminished, this may be offset by a continuation
of the public good rationale, or by the emerging
environmental externality rationale. According
to some analysts, these latter may be sufficient
rationales for continued public monopoly
ownership of Eledricite de France (nuclear) or
the Bonneville Power Authority (hydro)20
An additional issue is whether the techno-
logical trends that have undermined the natural
monopoly rationale in generation will eventu-
ally have similar effects for the remaining major
components of the electricity industry, trans-
mission and distribution. Some analysts specu-
late that the improving economics of smaller
and smaller generation units, notably combined
cycle turbines, fuel cells and solar-based tech-
nologies, may in future favour on-site electricity
generation ("distributed generation") such that
the monopoly position of transmission and
distribution monopolies will also be reduced
(Flavin and Lenssen, 1994).
Developments in the US have played a key
role in this erosion of the natural monopoly
rationale, although more radical market ex-
periments are now being conducted in other
countries, notably the UK, Norway, New
Zealand and Chile. In 1978, the US federal
govemment passed the Public Utility Regulatory
Policy Act (PURPA), forcing electric utility
monopolies to take supply from non-utility
generators if these were at lower cost than the
utilities' own planned supply units. While the
PURPA initiative was motivated in large part
by concern in the US about the use of imported
oil for electricity generation, the implications
for the natural monopoly rationale have been
considerable. The experience of the following
decade demonstrated a clear shift in the econo-
20/ In France one still hears the argument that the
time horizon of private investors is too short to
arrive at socially optimal electricity generation
investments. Nuclear investments, even if optimal
from a holistic social perspective, will tend to be
overlooked by the private sector on its own
because the investments are so capital intensive
and require such a long time for recovery of the
initial investment (Bouttes and Lederer, 1991).
114
mics of electricity generation, with smaller scale
technologies proving to be competitive with
conventional large utility supply projects.
Although PURPA initially required utilities
to pay private generators a price that reflected
the cost of electricity from the utility's next,
proposed generation project (its avoided cost),
it soon became apparent that non-utility supply
exceeded demand at this price. Utility com-
missions began to recognize the benefits to
customers of establishing bidding mechanisms
to ensure supply at the lowest possible price,
adjusted for various non-priced factors such as
risk and in some cases externalities. Competing
suppliers included il1depel1del1t power producers
(IFPs) and other utilities with surplus capacity.
Under this wholesale electricity competitiol1, the
utility functions as the monopsony purchaser
of electricity on behalf of its customers, but the
utility must accept the best bid for incremental
electricity supply, subject to various constraints
or other regulatory objectives. Because the
industry has grown little in the last decade, the
wholesale competition model has only experi-
enced limited testing thus far. However, whole-
sale competition has now been accepted by the
US federal govemment as at least a minimum
requirement in the evolution of the electricity
industry, as outlined in the Energy Policy Act
of 1992.
In the last few years, the debate about the
implications of lost scale economies has been
carried further, leading some to criticize even
the wholesale competition model and advocate
a retail competition model in its place. Accord-
ing to this argument, the wholesale competition
model still fails to maximize social welfare
because it substitutes the preferences emerging
from the utility commission regulatory process
for the preferences of individual consumers. If
the electricity market is now truly a competitive
market like any other, the argument goes, then
consumers should be allowed to make utility
maximizing decisions just as they would in any
other market (Galloway, 1994). We return to this
debate in Section 3.
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2.3 Erosion of the Public Good Rationale
The third force for change in recent times is the
erosion of the public good rationale for govern-
ment intervention in electricity markets. This
has been driven by mishaps with publicly
owned electric utilities, technological and
economic changes, and shifting political values.
A fairly extreme position is that govern-
ments and regulatory bodies are virtually
ineffective in directing investments in electric
and other markets to best satisfy the long-run
public interest. Thus, the argwnent goes, private
ownership is almost always preferred to public
ownership. Even in natural monopoly markets,
private ownership is preferred and regulation
should be minimized by the use of incentive
mechanisms such as price caps. As one might
expect, the rise to power of non-interventionist
political parties in some industrialized countries,
has been accompanied by various privatization
initiatives. The UK is the quintessential case,
where the privatization campaign touched many
sectors of the economy, including ports and
airports, aerospace, airlines, oil and gas, tele-
communications, automotive, and electricity.
The argument against government owner-
ship and other forms of intervention can be
explained in terms of the principal-agent problem
(Vickers and Yarrow, 1988). According to this
concept, the publicly owned corporation is an
agent of goverrunent assigned to meet the
government's objectives. However, the agent
may have different objectives than goverrunent
and as a result may frustrate or at least fail to
achieve the latter's objectives.
21
Thus, even with
acceptance of the view that governments are
generally motivated to maximize social welfare,
and also that certain sectors of the economy
exhibit significant market failures, concern over
the principal-agent problem may still lead one
to conclude that public ownership is an inef-
fective tool for addressing most legitimate argu-
21/ One can take the concept back one step further,
with the populace as the principal and government
as the agent, arguing that here too there will be a
discrepancy in terms of the inconsistencies between
the agent's and the principal's interests, and hence
the desirability of as little government as possible.
ments for market intervention.
While one's sense of the costs and benefits
of public ownership will undoubtedly be influ-
enced by ideological predispositions, there has,
in addition, been a general decline in enthu-
siasm for public ownership in recent years in
most industrialized countrie's. One argument
is that public ownership has not succeeded as
well as open regulatory processes in involving
the public in the major critical decisions about
electricity investment. Substantial debates on
this issue have occurred in recent years in
France, the UK, Canada, and several other
western countries. In publicly owned electric
utilities, key decisions are frequently made by
technocrats or political advisors without
meaningful opportunities for public partici-
pation. Major projects may be favoured because
of their political or technological attractiveness,
not because they maximize social welfare when
tested against the full range of legitimate
alternatives, with estimated public values on
external costs and benefits incorporated.
The experiences of the three largest Cana-
dian utilities are noteworthy. In the late 1970s,
British Columbia Hydro was increaSingly criti-
cized for planning large hydro-electric projects
throughout the province without fairly evalu-
ating financial and environmental risks, smaller
scale supply opporturrities, and energy efficien-
cy alternatives. The largest and most critical
investment decisions in the province were being
made by a group of technicians and bureau-
crats, with virtually no opportunity for public
input or review. Mounting public concern that
the agent was not at all serving the interests of
the principal convinced the goverrunent to place
its publicly owned utility under the regulatory
control of the provincial public utility com-
mission. This created the somewhat unique
situation in which a publicly owned utility is
regulated by a public agency. In effect, one
could say that the publicly owned utility was
created to address the natural monopoly and
public good market failures, while the layer of
utility commission regulatory control was added
to address the principal-agent problems of
publicly owned corporations. In spite of its
unconventional design, this institutional model
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has proven to be very successful compared to
other Canadian jurisdictions. BC Hydro has
been generally ahead of its Ontario and Quebec
counterparts in being responsive to public
concerns and in adjusting to new technological
and market developments of the kind outlined
in this paper. In particular, BC Hydro has been
an innovator in Canada in exploring demand-
side management options and incorporating risk
and other environmental and social factors into
its electricity planning framework.
In Quebec and Ontario, the legitimacy of
decisions by publicly owned utilities has been
especially challenged in the last few years.
22
As
recently as the late 1980s, both of these utilities
were still following the large project, supply-
focused path of the 1960s and 1970s. This is
exemplified by planning decisions in the late
1980s (1) to continue with an electricity supply
vision dominated by large scale nuclear power
projects in Ontario and (2) to continue with
massive hydropower projects in Quebec. In-
deed, by the late 1980s, these two Canadian
utilities were virtually the only large utilities
in the US and Canada whose plans were still
dominated by electricity supply megaprojects.
For many, it is no coincidence that these remain
the only two large, vertically integrated utilities
in the US and Canada that are not openli, and
fully regulated by a utilities commission. Not
surprisingly, both provincial governments have
recently initiated review processes that examine
options for addressing the principal-agent
concern, with the options ranging from shifting
to the British Columbia model to full priva-
tization.
In addition to the principal-agent concern,
there is another reason for the erosion of the
public good rationale. It is increasingly sugges-
ted that the public good attributes of electricity
have diminished in recent years. In particular,
the perception of electricity's public good
22/ See McKay (1983) for a review of interest
group mistrust of Ontario Hydro up to the 19805,
23/ Ontario Hydro's rates are reviewed in public
hearings by the Ontario Energy Board, but the
Board has no ratemaking authority and simply
makes recommendations to cabinet.
116
character has diminished in part because of the
changing assumptions about economies of scale
in generation; the same factors that undermine
the natural monopoly rationale can also
undermine the public good rationale.
First, it appears that the electric industry
may be less critical in the future in determining
the pace of economic development, at least in
industrialized countries. Once the electric grid
covers most of the country, the issue shifts from
access to electricity to the linkage between
electricity and economic growth. While elec-
tricity consumption and economic growth will
remain correlated, past assumptions about an
extremely tight causal relationship have been
undermined by evidence since the 1970s
(National Research Council - US, 1986).
Second, as the scale economies of generation
technologies shift in favour of smaller units (and
perhaps DSM), electricity generation invest-
ments will have less impact on the economy.
The slow-down and reduction in total industry
investment has allayed past concerns about the
effects of utility debt and utility technology
choices on the aggregate cost of capital, the
technological options for the rest of the econo-
my, and the consequences for counter-cyclical
macroeconomic objectives.
Third, there is unlikely to be any significant
development of large scale hydropower resour-
ces in industrialized countries in the future,
while nuclear remains important in only a few
countries. This reduces the rationale for public
intervention in new electricity generation
development, although there remains the dilem-
ma of whether or not existing hydropower
facilities are best managed by the private or
public sector. Thus far, it appears that the
general preference in the US will be to retain
public ownership of the major hydropower
entities, BPA and TVA.
Fourth, since the mid-1980s oil independence
has declined in importance as a national
security issue. While governments in the 1970s
and 1980s intervened in electricity markets in
order to influence the fuel choice away from
oil, changing economics have since favoured
natural gas and, in any case, the oil market is
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less vulnerable to political manipulation.
24
Fifth, in developed countries the electricity
grid has now been widely extended such that
access to electricity is no longer the social equity
issue it once was. However, the appropriate
pricing strategy for electricity remains a key
issue, with much of the public still supporting
uniform prices within each customer class,
regardless of location and the cost of providing
service. In developing countries, in contrast,
both grid extension and electricity pricing are
still critical issues relating to government inter-
vention in electricity markets. The issue hinges
on the trade-off between the benefits that a
publicly owned utility can provide by subsi-
dizing the nascent stages of economic devel-
opment, and the potential drain on the economy
that such utilities can become if they are ex-
tremely inefficient and make decisions for short-
term political expediency with no clear social
welfare maximizing objective. This issue has
become more pressing as the World Bank has
begun to demand refonn of the electricity sector
in developing cOW1tries as a precondition to
continued financial support
25
3. The Future: Convergence or
Flexibility?
The thesis presented in Section 2 can be
summarized with the help of Figure 1. On each
axis the diagram shows one of the three major
rationales for public intervention in electricity
markets: natural monopoly, public good and
environmental externality. The other end of
each axis represents the absence of such a
rationale. The thesis of this paper is that there
has been a shift from the lower right to the
upper left of Figure 1 as a result of changing
technological conditions and public perceptions.
While these perceptions vary between countries
24/ The issue of fuel choice and political
independence has not completely disappeared. In
Europe there is a concern that competitive elec-
tricity markets would favour natural gas which
increasingly must be imported into Europe from
unstable countries like Russia and Algeria.
25/ See, for example, World Bank (1993).
and individuals, a general shift has occurred
because of the widespread emergence of the
externality rationale and the erosion of the
natural monopoly and the public good ratio-
nales.
3.1 Conflicting Models of the Future
This evolution is creating fundamental challen-
ges to current institutions and policies, but there
is no consensus on the appropriate govemment
response to these challenges. lndeed, very
different positions are being advocated.
26
Here
are four distinct positions.
1) Competitive generation markets are not
desirable because of the continued importance
of the public good rationale and the emerging
externality rationale
2
?
2) While the demise of the natural monopoly
rationale implies the need for competition in
generation, this should be wholesale compe-
tition regulated by utility commissions, in order
for the electricity sector to be able to effective]?'
address the emerging externality rationale
2
3) The demise of the natural monopoly rationale
implies the need for break-up of the vertically
integrated monopoly, introducing retail compe-
tition in generation because this has the greatest
potential to fully meet consumers' needs.
Moreover, because externality issues are en-
demic to the entire economy they should be
addressed by different means, not by misusing
market intervention mechanisms that were
developed more appropriately to address na-
26/ For a detailed analysis of some specific models
of industry structure, see Tenenbaum et al (1992).
27/ This argument still dominates in France, where
it is believed that only this model can assure the
long run benefits of a technology as complex and
significant as nuclear power (Bouttes and Lederer,
1991). This type of argument is still vigorously
advocated throughout other industrialized and
developing countries as support for the continua-
tion of publicly owned utilities.
28/ This argument is currently associated with
Ralph Cavanagh of the Natural Resources Defence
Council in the US. See, for example, Flavin and
Lenssen (1994) and Gegax and Nowotny (1993).
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29/ This is the argument expressed in support of
the California Public Utility Commission's recent
decision to implement retail competition in elec-
tricity. See, for example, Galloway (1994).
30/ This was a common sentiment in the U.K.
privatization initiative
r
and in part explains the
minimalist approach to regulating the transmission
and distribution segments of the U.K. electricity
industry. In Canada, the argument is associated
with Energy Probe, a non-governmental interest
group organization in Ontario.
tural monopoly29
4) The demise of both the natural monopoly
rationale and the public good rationale implies
the need for both privatization and deregulation
of the entire electricity sector. Environmental
problems should be taken care of separately.3o
It is the thesis of this paper that these wide
ranging positions on the appropriate response
to the evolving rationales for market inter-
vention are explained in large part by the ideo-
logical predispositions of the advocates of each
position. In particular, many of these advocates
seem to develop arguments that focus especially
on change that has occurred with just one of
the rationales for intervention
r
while ignoring
or down-playing what is happening with
respect to the other rationales. Thus, for ex-
ample, the argument that the decline of the
natural monopoly rationale in electricity gen-
eration must imply privatization assumes away
the potential importance of the other two ratio-
nales for intervention. Similarly, the argument
Competition
Private
Good
Figure 1
Externalities
No Externalities
Public
Good
Natural
Monopoly
that retail electricity competition must be
stopped under all circumstances, implies that
it is not possible to develop alternative means
of dealing with externalities or other aspects of
the long-run public interest. Finally, the argu-
ment that the erosion of the natural monopoly
rationale in electricity generation eliminates the
ability to mandate IRP neglects the crucial fact
that a natural monopoly will still exist in
transmission and distribution, and that DSM
and IRP remain desirable as part of the package
of cost-effective policies for addressing envi-
ronmental externalities.
The goal for this final section of the paper
is to speculate on what these developments
should imply for the future character of gov-
enunent intervention in electricity markets. The
speculations are broad because each society will
weigh and trade-off the issues according to its
own values and priorities. But hopefully the
public policy decisions that shape electricity
markets in the future will be well informed
ones, mindful of the full set of rationales for
government intervention and of the evolVing
justification in support of each rationale. The
critical question, therefore, is whether the
changes in rationales for intervention described
in this paper imply that only one model is
appropriate for future government regulation
- regardless of differences in each society's
institutions
r
technologies
r
resources, economic
system
r
political concerns, or interventionist
predisposition - or if several alternative
models may be appropriate.
The answer is both yes and no. Yes, the
shifts in intervention rationales imply forces of
change that will impact everywhere. These are
referred to below as forces of convergence.
However, the forces of convergence will not be
strong enough to require every country or
region to follow an identical model of govern-
ment intervention. There is flexibility that will
allow each country or region to significantly
shape the overall character of its electricity
market interventions. These are referred to
below as margins offlexibility.
Figure 2 portrays on a continuum some
possible outcomes of these converging and
differentiating trends. The left end of the
118
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N o n ~
Interventionist
Highly
Interventionist
1--------+---------1
verlically diflerentia1ed
priva1e ownerShip
competition in generation
lrarK:hise bidding lor
conlinued natural mOl1<)poly
11<) regulation
ver1icaliy dillerenliate<l
private ownership
compelilion in generation
regulation 01 continued natural
monopoly
environmen1a!.regulalion
ver1ically dillerentlated
mix ot public and priva1e
ownership
regulalion ot continued na1ural
monopoly
environmental regulalion
ver1iCally Inlegraled
publocallyowned
monopoly
Figure 2: Models of Government Intervention in Electricity Markets
continuum represents a minimalist approach
to market intervention. The right end represents
a strongly interventionist approach. While these
two extremes are possible outcomes, it is more
likely that the forces of convergence will push
most countries toward the middle of the
continuum. However, in the middle area there
should remain considerable room for flexibility
among the approaches taken by different
countries and regions.
3.2 Forces of Convergence
These are some of the key forces of convergence
that will tend to push governments toward
similar policies.
COMPETITIVE GENERATION POTENTIAL WILL
CREATE PRESSURE FOR ALLOWING ELEC1RICITY
COMMODITY COMPETITION
The change in the economics of electricity
generation, if the trend persists, will create a
strong pressure on governments to allow
private generation competition and direct com-
modity transactions between producers and
consumers. A key reason relates to the princi-
pal-agent problem. There is a strong preference
in most industrialized countries - and increas-
ingly in other parts of the world - for consu-
mer choice over central planning. To the extent
that competitive markets are feasible, govern-
ments with a predisposition to non-intervention
will shift to competitive markets, and this will
be difficult to overturn, even by subsequent
governments with a penchant for intervention.
A second reason relates to market disequi-
librium. It is currently argued in the US that
planned electricity supply can lead to the same
low costs as private competitive electricity
supply. This could be possible if cost structures
were perfectly predictable. But they are not. In
private markets just as in planned markets,
there will continue to be mis-investments. But
in a private market it is the investor who loses
out as new investors are able to enter the
market and sell at lower prices. In planned
supply markets (regulated private ownership
or public ownership), there will be a greater
tendency to make the customer cover part of
the costs of mis-investment via higher rates.
31
,32
31/ Cost recovery from customers is not always
guaranteed; the regulatory compact was in part
broken when utility commissions in the US in the
1980s did not allow full recovery of nuclear plant
costs, sometimes even when these very commis-
sions had earlier approved plant construction.
However, it is generally easier in the regulated
context to make the customer help pay for mis-
inveshnents.
32/ One hears the arguments that there would be
no interest in competition today in the US if not for
the mis-inveshnents in nuclear power, and that
once these are amortized or written off the interest
would dissipate. But electricity markets are always
more likely to be in disequilibrium than eguili-
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FREE TRADE AGREEMENTS WILL HINDER THE
ABILITY TO PREVENT PRIVATE GENERATION
COMPETITION
Countries with a predisposition to retain
publicly owned monopolies in generation will
be under pressure to adjust their position at
least somewhat by free trade protocols. Thus,
for example, Electricite de France will be under
pressure from the organizations of the European
community to allow some form of competition
in its generation market. Examples of other
countries that will also experience this kind of
pressure are Mexico and Canada.
INTERNATIONAL ENVIRONMENTAL AGREEMENTS
AND DOMESTIC PUBLIC PRESSURE WILL REQUIRE
CON"TINUED ELECTRICITY MARKET
INTERVENTION
Governments will be under domestic and/or
international pressure to address the environ-
mental externalities of electricity generation.
33
Intervention policies may focus on several
objectives, including energy efficiency, fuel
SWitching, emission reductions, lifestyle chan-
ges, and infrastructure design. Categories of
policy instruments include regulations, taxation,
subsidies and information campaigns. All of
these will undoubtedly be used in one manner
or another. Pressure for cost-effectiveness in
policy will continue to push governments to
seek synergies among intervention mechanisms.
The ability to find synergies will depend,
however, on the relative importance each
government places on each of the three
rationales for intervention.
brium.
33/ This obligation may seem the least obvious
today in the U.K., where electricity generation
competition has coincided with environmental
benefits as natural gas substitutes for coal. How-
ever, there is no reason why this convenient coin-
cidence will continue indefinitely; even natural gas
electricity generation has environmental costs.
120
CONTINUED NATURAL MONOPOLY IN
TRANSMISSION AND DISTRIBUTION WILL
REQUIRE CONTINUED IJ\JTERVENTION
A strong rationale for intervention in electricity
markets exists as long as there is natural
monopoly in transmission and distribution.
While approaches to intervention can be mini-
malist (e.g., a price cap), there will be pressure
to ensure long run economic efficiency and to
prevent high monopoly profits by private elec-
tric utilities.
34
Also, even with a minimalist
approach there will be pressure to require IRP
processes and develop DSM programs at the
transmission and distribution level in order to
address environmental objectives. Programs
may be restricted to those that do not affect the
rates of non-participating customers. But even
if the programs did increase the transmission
(and/ or distribution) service rates of non-
participating customers, such expenditures
would be possible even under a scenario of full
retail competition. Only in extremely rare cases
would the slightly higher transmission service
charges of a utility engaged in prudent DSM
programs be sufficient to be the determining
cause in the decision of large industrial
customers to self-generate or build transmission
bypass.
ENERGY EFFICIENCY WILL REMAIN A USEFUL
TOOL FOR ADDRESSING ENVIRONMENTAL
EXTERNALITIES
Governments will continue to recognize that
34/ Woolf (1994) describes some of these pressures
on the recently established regulatory agency in the
UK. The extreme contrast betvveen micro-man-
agement and incentive approaches to regulation is
frequently over-emphasized. It is possible to devel-
op hybrid regulatory approaches that award speci-
fic returns on equity but that use various adjust-
ment formulas and other incentives to keep de-
tailed regulatory hearings down to about once
every three years, thereby giving the regulated
company time to pocket some of the profits from
legitimate efficiency efforts. Innovations in this
direction are currently under development in the
US and Canada.
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energy efficiency will playa critical role in the
public policy response to concerns over environ-
mental externality. In some cases, governments
will establish separate energy efficiency agencies
or funds, as has occurred in New Zealand,
France, the UK and other countries. However,
in many cases governments will also follow the
model developed in the US, in which regulated
utilities implement IRP processes that include
cost-effective DSM targets and implementation
mechanisms. The lesson from the US experience
is that a utility-led marketing focus on energy
services can reveal significant opportunities for
relatively low-cost environmental benefits, and
that increasingly DSM programs can be
implemented in ways that inform rather than
bribe or otherwise manipulate consumer choice.
Moreover, as noted in (4) above, IRP processes
and DSM programs can be implemented by
utilities even when the industry is no longer
vertically integrated, with the regulated
transmission and/or distribution utility respon-
sible for IRP.
35
MAJOR WORLD LENDING INSTITUTIONS WILL
INFLUENCE MARRETS IN DEVELOPlJ'iG
COUNTRIES
Dependence on foreign capital will intensify the
pressure on developing countries to allow
private generation competition and will restrict
their freedom to override economic efficiency
objectives using the public good rationale. Thus,
previous assumptions that grid and distribution
expansion increased social welfare, regardless
of cost, will be restrained by more rigorous
lending criteria. In addition, the construction
and operating costs of electric utilities will be
more tightly controlled, in part by exposing
publicly owned monopolies to competitive for-
ces. This could have many variations, including
(a) subcontracted private construction and
operation with public ownership retained, (b)
35/ While some analysts suggest that the US 1992
Energy Policy Act was inconsistent in encouraging
generation competition along with greater utility
directed IRP, that policy is consistent with the
approach described here.
private construction and regulated private
ownership, and (c) franchise bidding for private
operation and ownership with negligible
regulation, and (d) independent regulation of
publicly owned utilities.
3.3 Margins of Flexibility
These are some of the key margins of flexibility
that will allow governments to vary their re-
sponse to electricity market failures in accor-
dance with their country or region's specific
institutions, technologies, resources, economic
system, political concerns, and predispositions
regarding intervention.
PREDISPOSITIONS TOWARD MARRET
INTERVENTION WILL VARY
The political predisposition to intervene in
markets will vary in time and space. For
example, if the Conservative party had not
retained power after 1988, the UK electricity
market would probably be very different today.
In contrast, there is still a consensus among
major political parties in France that a publicly
owned, vertically integrated natural monopoly
is in the long-run public interest. To the extent
that other market attributes allow for flexibility
in the choice or degree of market intervention,
this predisposition factor will playa role.
TECHNOLOGIES AND RESOURCES HAVE SPECIAL
ATTRIBUTES
Nuclear power is a technology that tends to
require state intervention. There is a reciprocal
aspect. Jurisdictions that have a propensity for
electricity market intervention, like France, will
be more willing therefore to opt for nuclear
power. Jurisdictions that now have nuclear
power may be required to retain government
intervention even if they would rather not, as
is the case in the 13K. Hydropower is an
example of a special resource. The US federal
government retains ownership of BPA and TVA
even though it generally prefers private
ownership in electricity generation. Public
ownership is much more significant in Canada
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where hydro-electricity predominates, even
though the Canadian natural gas industry is
almost completely privately owned and publicly
regulated like its counterpart in the US.
ALTERNATIVES FOR DEALING WITH THE
TRANSMISSION AND DISTRIBUTION NATURAL
MONOPOLY
In spite of the emphatic arguments on both
sides, there is not a strong argument today
favouring either private or public ownership of
electricity transmission and distribution. The
natural monopoly rationale for intervention still
exists, and there is no compelling evidence that
private, but regulated, systems are more or less
efficient than public systems. Thus, govern-
ments are unconstrained in their decision to opt
for one or the other form of intervention, which
will therefore probably be determined by some
other factor, notably the government's general
predisposition toward public or private
ownership.
OPTIONS FOR DEALING WITH EXTERNALITlES
AND FOR FOSTERING ENERGY EFFICIENCY
As noted in the previous section, there are
many options available to government for
dealing with externalities and for fostering
energy efficiency. Governments can pursue
policies that require direct participation by finns
in the electricity sector, an example being the
approach advocated in the US Energy Policy
Act of 1992, involVing IRP, DSM and resource
bidding for electric utilities. Or, governments
can develop separate agencies, funds and policy
instruments, an example being the US Clean Air
Act of 1990. Again this means that other factors
will determine the outcome in each country or
region.
DEVELOPING COUNTRIES HAVE SPECIAL NEEDS
Finally, in spite of the increased influence from
international finance agencies, the needs in the
electricity sector of each developing country will
be different, perhaps even of each region within
a developing country. For example, in the
122
eastern regions of China a significant private
sector role may now be appropriate. The
transmission grid has been extended to many
regions and, with the recent dramatic economic
growth, there are opportunities for profitable
private investment in generation, with appro-
priate government regulation, including the
pursuit of environmental objectives. In more
isolated regions of China, as in many devel-
oping countries, grid extension and even gen-
eration resources may still require a significant
role for the public sector, or at least private
sector initiatives that are subsidized and/or
closely regulated in order to coordinate them
with government economic development plans.
3.4 Reconciling Environmental, Public Good and
Competition Imperatives in the Canadian
Context
Decisions about public intervention in electricity
markets will depend on how each society
weighs the three main rationales for inter-
vention outlined in this paper. This can lead to
very different models depending on the unique
circumstances facing each country or region. No
one model should be presumed to be
universally applicable; each society will make
its own choice.
In making that choice, it is important that
a focus on one rationale not lead to muddled
thinking about the other rationales. Many
questions therefore need to be addressed in
each jurisdiction and the responses may differ
substantially from one region/country to anoth-
er. Here are some of the key questions.
What other intervention mechanisms exist or
will be created to address environmental exter-
nalities?
What other intervention mechanisms exist or
will be created to encourage cost-effective
energy efficiency?
How important is consumer choice for
maximizing social welfare in the case of
electricity?
What are the most favorable supply
technologies, and what are their optimal invest-
ment and operating requirements?
What are the technical and economic
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advantages of centralized monopoly control of
electricity supply in each jurisdiction?
What are the options for competitive elec-
tricity supply?
What institutional arrangements are required
for competitive electricity supply, and how ef-
fective can they be?
What is the likelihood of failures or abuses
of various types of public intervention mecha-
nisms?
What is the current level of economic
development of the country or region, and what
is required for future economic development?
As a conclusion to this paper, the review
exercise suggested by the above questions is
conducted for the electricity sector in British
Columbia. This provides a concrete example of
what the approach advocated in this paper
might lead to in terms of scanning policy
recommendations for a specific jurisdiction.
The model depicted in Figure 3 represents
an attempt to balance the current and likely
future realities of the three rationales for
government intervention in the electricity sector.
In particular, it is based on the following con-
clusions.
1) PRIVATE MARKET COMPETITION FOR
INCREMENTAL GROWm IN GENERATION IS
DESIRABLE.
In BC, the generation assets of BC Hydro could
be separated from transmission and distribution
(T&D), with the existing assets competing with
IPPs for either wholesale sales to the T&D
utility or retail sales to customers, if allowed. In
one scenario, all increases in generation assets
could be restricted to the private market in a
competitive process regulated by the BC
Utilities Commission and managed by BC
Hydro, in the case of wholesale competition, or
decided by consumers, in the case of retail
competition. In another scenario
l
Be Hydro
would be allowed to compete with IFPs for new
generation, but in this case the regulation of this
process and of BC Hydro must ensure that there
are no cross subsidies from existing assets and
that resource selection is unbiased. In addition,
BC Hydro's power in the generation market for
the foreseeable future would require continued
rate regulation.
If retail commodity competition were
permitted, effective means must be in place to
deal with the externality issue. Environmental
controls on IPPs
r
via the environmental review
process and the energy project certificate
requirements (or any other comparable govern-
ment policies analogous to the US Clean Air
Act), should be designed to ensure that no IFP
is initiated or captures market share solely
because of externality costs that have been
ignored.
2) HYDRO AND NUCLEAR GENERATION ASSETS
COULD BE PRIVATIZED, BUT mERE ARE PUBLIC
GOOD ARGUMENTS AGAINST THIS.
The operation and maintenance of existing
hydro and nuclear power generation assets
retains public good attributes (or public liability
attributes in the case of most UK, US and
Ontario nuclear facilities), suggesting that the
rationale for public ownership is still fairly
strong. Since most of BC Hydro's generation
assets are hydropower facilities, there is a case
for retaining public ownership, provided that
the cabinet has an effective external control
system to ensure efficient management. In BC
this is provided by the regulatory overview of
the BC Utilities Commission and by the Crown
CorporatiOns Secretariat, an advisory oversight
agency of cabinet.
3) T&D REMAINS A NATURAL MONOPOLY, AND
COULD BE PUBLICLY OR PRIVATELY OWNED.
The T&D assets and the short-run market
coordination filltction remain natural mono-
polies. Whether private or public, the T&D
utility should be regulated by the BC Utilities
Commission in order to prevent the capture of
monopoly rents (in the public ownership case,
regulation is also intended to address the
principal-agent problem). The T&D utility
would fW1ction as a common carrier (retail
competition) or as a purchasing agent (whole-
sale competition), in either case with published
and regulated transmission and distribution
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ND
DiSlribUled Gellenllioll
Self-Ceneration
or IPP Bypass
!PI's
i
ij
IMPORT
B.C. HYDRO
[ill
[j

BCn EXISTING
,',', ',', ,',' Nw GENERATION
ASSETS
. ,
I.

Ir

S.C. HYDRO
TRANSMISSION &
DISTRIBUTION
(/RP/DSM)
'---.. ---------------.
1: 1
I
. : :
.::
I
..
LEGE

Retail Co
--"
Wholesale
EndUse
Distributed
Generation!
SelfGeneralion
Distribution
Generation
Transmission
Figure 3: A Sustainable Model for BCs Electricity Industry
tariffs. The T&D component could be either a
single entity or divided into a transmission
company and a distribution company. This
latter option may be desirable especially if there
are perceived public good and/or environ-
mental benefits to greater regional control of
distribution systems. This split was carried out
in England as part of the privatization initiative,
while in Norway and Denmark, for example,
the regional/local utilities remain publicly
owned, generally at the local level.
4) THE T&D UTILITY CAN BE RESPONSIBLE FOR
IRP/DSM.
The assessment of energy service cost-effec-
tiveness from the customers' perspectives need
not be conducted by a regulated utility because
the issues of IRP extend beyond the regulated
utility sector to include consumption of other
energy forms (oil, coal, biomass, etc.) and
consumers who are not served by the utility
(isolated regions or communities). However,
there is a counter-argument that utilities are
best placed to assist customers in assessing their
energy service options, and that governments
interested in the environmental benefits of
energy efficiency would want to continue to
encourage utility-led IRP105M. Thus, IRPIDSM
activity could remain the domain of the T&D
utility, including, however, coordination and
collaboration with more broadly applicable
initiatives of the energy and environment
ministries. Costs of IRPIDSM can be recovered
from a levy on T&D service charges. However,
DSM initiatives should probably avoid cross-
subsidies between customer classes and attempt
to minimize cross-subsidies between partici-
pants and non-participants within customer
classes in order to reduce the risks of load
displacement inveshnents that are triggered
simply to avoid IRPIDSM costs.
124
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5) REGULATION, WHETHER OF PUBLIC OR
PRIVATE T&D ENTITIES, SHOULD SEEK TO ENSURE
THAT INCENTIVES FACED BY UTILITY
MANAGEMENT ARE CONSISTENT WITH SOCIAL
WELFARE OBJECTIVES.
All regulation is incentive regulation in that it
creates a framework of incentives for utility
management. Regulation of the T&D utility
could provide incentives for operating efficien-
cy. One mechanism is to establish price adjust-
ment formulas, tied to inflation and produc-
tivity factors, that reduce the need for frequent,
detailed regulatory review, and allow utilities
to keep short-term profits garnered from ac-
celerated productivity gains. Regulation of the
T&D utility could also remove incentives to
build the rate base where that is not the optimal
utility action. One mechanism is to decouple
utility short-run profits from commodity sales.
A complementary mechanism is to provide
additional rewards for desired activities, such
as assisting customers with least-cost energy
service evaluations and measures.
This sketch of policy options in British
Columbia has some elements that apply
specifically to that province, but it also has
many generic elements that could be applied
to other Canadian provinces. For example, in
Ontario the assets that are likely to remain in
public ownership are hydro and nuclear gen-
eration, while in Quebec they would be hydro
generation. Also, in both Ontario and Quebec,.
the principal-agent problem with publicly
owned corporations suggests the need for
regulatory control by an independent agency
with a responsibility for public involvement.
Ontario would also be faced with additional
transitional challenges in moving to this pro-
posed model. Presumably, the government
would want to protect current high cost gen-
eration assets from full IFP competition. In the
UK, nuclear assets have been protected by a
special levy on all electricity consumption,
although this is slated to decrease or disappear
over time.
In Alberta and some other provinces, the
same extent of public ownership either does not
exist or is not necessary. In any case, the T&D
utility must still be regulated. However, Alberta
may prefer that all energy efficiency and
environmental externality issues be dealt with
outside of the utility commission regulatory
process. This may work as long as there are
effective mechanisms using other government
instruments.
In summary, while this concluding section
obviously does not purport to resolve the issues
of future government intervention in Canadian
electricity markets, it sketches some of the
salient features of likely models based on an
assessment of the interplay of the forces of
convergence, the margins of flexibility, and
some of the unique characteristics of Canada's
regions.
Rationales for government intervention in
electricity markets have evolved substantially
in recent times, and this has engendered a
period of debate, experimentation and consider-
able confusion. Sorting through the issues in
order to arrive at good public policies will not
be easy. But the outcome is especially in doubt
if the issues and rationales are not clearly un-
derstood. The goal of this paper is to contribute
to that understanding so as to facilitate better
public policies.
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